In the following analysis, Adam Owens CTA, Partner for Tax Advisory at top 20 accounting firm, Xeinadin, shares practical, detailed insight for advisers on what the new changes to pensions and IHT can mean for clients’ financial plans and the scale of how the changes can impact the value of estates.
It’s now more than three weeks from the most highly anticipated Budget since Sir Geoffrey Howe’s in 1981. Whilst the increase in employer National Insurance Contributions stole initial headlines, realisations have begun to dawn on the severity of the changes to inheritance tax (IHT). For many, it is these changes that are now garnering the most visceral reactions.
While farmers and landowners have spoken with the loudest voices – and the changes to Agricultural Property Relief (APR) and Business Property Relief (BPR) are significant – in this article we focus on the changes to pensions.
It is arguably those intending to leave pension pots for their next of kin that may incur the greatest relative tax hit without forward planning – pensions may now suffer taxes of up to 91.3%.
The new pension tension
Pensions are often the second most valuable asset after the family home. Following removal of the lifetime allowance in 2023, pension values have risen across the UK. With the official retirement age getting older and older, many clients seek solace in being able to build a solid pension pot which – if it isn’t used in their lifetime – can be passed through the estate to their beneficiaries.
Historically, pensions have represented a very effective inheritance tax planning tool. The vast majority of pensions fall completely outside the inheritance tax net, and are therefore often the last source of income to be used in retirement. For many it’s a nice thought, that when they pass away, their children can benefit from these hard won savings.
However, from 6th April 2027 this may no longer be the case. The chancellor has announced that unused pension funds and death benefits will be included within the value of a person’s estate for inheritance tax purposes. Whilst on its own this may not seem hugely significant, is important to work through the numbers to understand the full extent of the impact this will have.
Firstly, inheritance tax liability on the pension itself resulting in a loss of up to 40% of the pension fund. But for many there will be a further impact. Including the pension in the estate will result in the total value exceeding £2 million. Where this happens, the residential nil rate band – up to £175k per taxpayer or £350k for a married couple – can be reduced or removed.
Finally, beneficiaries will continue to be subject to income tax on the drawdown of funds from inherited pension schemes. In most instances, where the pension is inherited from someone that survived past the age of 75, the remaining pension fund (after inheritance taxes) will then be subject to income taxes at rates of up to 45%.
Looking at the numbers
Here is an example of how significant these inheritance tax changes could be:
Sarah is a widow, who inherited the entirety of her late husband’s estate, and dies aged 76 owning the following assets:
- Main home, valued at £1 million
- Savings, valued at £1 million
- Pension fund, valued at £700k
Until 6 April 2027, the pension is relieved from inheritance tax, leaving only the main home and savings taxable. Assuming the conditions for the residence nil rate band (RNRB) are met, there would be an inheritance tax (IHT) cost of £400k.
From 6 April 2027 onward, the pension is brought into the scope of inheritance tax and the following tax implications arise:
- The removal of RNRB – the estate now exceeds £2.7m resulting in a tax cost of £140k (2 x £175k at 40%)
- IHT on pension at a tax cost of £280k (£700k @ 40%)
- Income tax on drawdown by son of residual pension value – which is £520,900 as IHT payment is split proportionately – resulting in drawdown at tax cost at 45% of £234,410
The total tax cost resulting associated with the £700k pension is therefore £674,410 … or effective tax rate of 91.3%!
Whilst the numbers in this example have been cherry picked to show a particularly bad example, it does show the true scale of these new changes.
The primary issue here is that, unlike many assets where value realisation is a capital event (and therefore benefit from the uplift in the death estate), pensions can only be accessed as income. As a result, there is a genuine double taxation as the pension is accessed.
How do you solve a problem like IHT?
The inheritance tax planning landscape is set to change significantly in the coming years.
Whilst it was typically advisable to keep your pension until last – and spend your other taxable savings first – from April 2017 onwards this may no longer be advisable. Pensions funds are generally non-transferrable, other than on death, making them a difficult asset from an inheritance tax planning perspective. This often isn’t the case with other investments.
Accessing pensions earlier – so that cash is held in a more flexible vehicle, such as a personal bank account or family investment company (FICs) – may now be more beneficial.
The associated income tax cost on pension drawdown will need to be managed. But given that recipients would have been taxed at income tax rates in any event, this may not be an insurmountable issue.
Whilst estate planning with pension funds will provide some unique challenges, many of the tried and tested inheritance tax planning strategies will still be applicable. We are certainly seeing renewed interest in traditional estate planning measures, including lifetime gifting, trusts and FICs since these changes were announced.
It is important to also be aware that any gifts from surplus income are, when strict conditions are met, treated as exempt from inheritance tax. Unlike most gifts, which fall outside the estate after only 7 years, gifts from surplus income can immediately fall outside the estate. It seems quite apparent that a large pension drawdown could be treated as “surplus income” in the correct circumstances, providing an interesting opportunity for tax planning in this area.
In closing, as with any new tax measure, it isn’t all doom and gloom. It is simply a matter of understanding and adapting to the new tax rules and, as ever, affected taxpayers should seek guidance from suitable qualified advisors.
The old adage “you can’t take it with you” has never been truer!
Adam Owens CTA is the Partner for Tax Advisory at Xeinadin, a top 20 firm of accountants and tax specialists across the UK and Ireland.
